Chapter 6

Investors in the share market

True/False questions1. T Investing in shares of publicly listed corporations should, on average, over time provide a higher return than investing in fixed-interest securities.2. F Investments through a stock exchange are limited to ordinary shares and preference shares issued by listed corporations.3. F Portfolio theory contends that a diversified share portfolio enables an investor to reduce significantly the portfolios exposure to systematic risk.!. F " share that has a beta of 1.2 is t#ice as risky as an average share listed on a stock market.$. T %hares that typically demonstrate a negative price correlation #ill usually move in the opposite direction if ne# economic information comes to the market.&. T 'ith dividend imputation, a shareholder #ith a marginal tax rate that is lo#er than the company tax rate #ill pay no tax on a fully franked dividend received, and the excess credit can be applied against other assessable income.(. T " companys li)uidity, that is, its ability to meet its short-term financial obligations, may be measured using the current ratio and the li)uid ratio. *f the t#o ratios, the latter is the more stringent measure.+. F It can be safely inferred that a company #ith a lo# current ratio is a riskier investment than a company #ith a high current ratio.,. T In comparing the profitability of different companies that have )uite different financial structures, the use of the -.I/ to total funds employed ratio #ould be more suitable than the -.I/ to shareholders funds ratio.10. F 1iven that the banking sector consistently displays a higher debt-to-e)uity ratio than do other sectors of the market, it can be reasonably concluded that there is a greater level of risk associated #ith investments in this sector.11. T " price to net tangible assets ratio of less than 1 indicates that the book value of the companys assets exceeds the markets valuation of the company.12. F " sensible investor #ould prefer to buy shares in a company that has a lo# price to earnings ratio, since this ensures that the investor #ill receive a relatively good return on the price paid for the share.13. F " company announces the payment of an interim dividend of &$ cents per share. /he cum-dividend shares are trading at 212.&0. /he theoretical ex-dividend price #ill be 213.2$.1!. T /he issue of bonus shares merely changes the composition of the firms e)uity as bonus issues do not add to the firms capital.1$. T In a one-for-nine bonus issue, if the cum-bonus price of the share #as 210, then the theoretical ex-bonus price #ould be 2,.1&. F " pro-rata rights issue that has a 100 per cent take-up rate simply increases the number of shares issued and has no effect on the companys capital.1(. T If a rights issue is renounceable, the right may be sold by a shareholder to another party before the exercise date.1+. T In a one-for-five rights issue, priced at 22 a share, and #ith the shares valued at 22.!0 cum-rights, the theoretical ex-rights price of the share #ould be 22.33, and the value of the right #ould be 20.33.1,. F /he global industry classification standard 31I4%5 is a measure of the li)uidity in ma6or stock -market indices around the #orld.20. F A share price accumulation index measures changes over time in the price of shares included in the index.Essay questionsThe following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.1. Let us assume that you have recently been appointed the manager of a large investment portfolio held within a superannuation fund. Your immediate task is to review the structure and operation of the portfolio prior to making any investment decisions. Identify and briefly discuss important issues that you will consider. (LO 6.1) 7i)uidity8secondary market, conversion of shares to cash 9isk8variance, standard deviation, beta, volatility Integrity8company, management, market 4harges8management fees, brokerage, stamp duty 3if applicable5 9eturn8dividends, capital gro#th, degree of risk 4apital gro#th8inflation, interest rates, economic and business cycles "ccessibility8primary market, secondary market, time :lexibility8portfolio restructuring, active investment, passive investment /axation8income tax, capital gains tax, dividend imputation 3if available5 %ocial security8effect of investment on income test and assets test 3if applicable5 -fficient price discovery8information transparency, absorption, current price /ype of investing8active versus passive, diversification of shares .uying and selling shares8systems, direct, managed, stockbroker, access, fees.2. Ms Brown has an investment portfolio comprising Australian shares. At a meeting with her investment advisor she requests explanations of the following: (LO 6.1)(a)the definition of systematic risk and unsystematic risk and an explanation of factors that are responsible for the two types of risk? In its basic form, risk comprises components of probability, variance, volatility and uncertainty. Probability is a statistical estimate of a variance in an expected outcome. ;olatility relates to the degrees of change that historically have occurred in outcomes over time and uncertainty is the possibility that an unexpected outcome might occur. %ystematic risk is exposures of a share portfolio to changes in the environment that have the effect of impacting the ma6ority of shares listed on a stock exchange. :or example, changes in interest rates, exchange rates or economic activity. <nsystematic risk relates to exposures that specifically affect the share price of a particular corporation. :or example, loss of key personnel or systems, or a do#ngrade of performance forecasts.(b) What is the rationale behind the assertion that an investor should not expet to be re!arded "or the unsystemati risk element in a share port"olio# "n investor is able to minimise unsystematic risk by holding a diversified investment portfolio= for example, a portfolio of shares, property and fixed interest investments. 'ithin the share portfolio the investor can hold shares in a number of companies, a range of industry sectors, and across different countries. /herefore, as investors are able to hold diversified investment portfolios, prices #ill not incorporate a significant risk component for unsystematic risk.$% &n investor holds the "ollo!in' stoks in an investment port"olio(*cka 7imited 2&$00 beta 0.+0/echno 7imited 2+&00 beta 1.10>ega .ank 7imited 2(,00 beta 0.($(a) Explain the beta oe""iient "or eah o" the stoks% .eta is the amount of systematic risk that is present in a particular share relative to an average share listed on a stock exchange. "n average share has a beta of 1.0. In the above portfolio, *cka 7imited has +0 per cent of the systematic risk of an average share= /echno 7imited has 110 per cent and >ega .ank 7imited ($ per cent of the average risk.(b) What is the level o" risk o" the port"olio as measured by beta# /he #eighted average beta of the portfolio is?&mount )ort"olio *eta Wei'hted !ei'ht betaOcka Limited $6 500 0.282609 0.80 0.226087/echno 7imited 2+ &00 0.3(3,13 1.10 0.!1130!>ega .ank 7imited 2( ,00 0.3!3!(+ 0.($ 0.2$(&0,'eighted average beta @ 0.+,$000() I" the investor added to the port"olio !ith the purhase o" +,--- !orth o" shares in *ibs . *obs /imited (beta 0%1,)2 !hat impat !ould that purhase have on the risk struture o" the port"olio# (/3 6%0) If the investment in .ibsA.obs is added to the portfolio the #eighted average beta of the portfolio becomes?&mount )ort"olio *eta Wei'hted !ei'ht beta.ibsA.obs 7imited 2$ 000 0.1(+$(1 1.2$ 0.22321!*cka 7imited 2& $00 0.2321!3 0.+0 0.1+$(1!/echno 7imited 2+ &00 0.30(1!3 1.10 0.33(+$(>ega .ank 7imited 2( ,00 0.2+21!3 0.($ 0.211&0('eighted average beta @ 0.,$+3,2 .y adding the risky investment in .ibsA.obs the investor has been able to actually lo#er the average systematic risk associated #ith the portfolio. /hat is, the average #eighted beta is no# closer to the market average beta of 1.4% As an investment adviser for a managed fund that invests in Australian resources shares, you must advise clients on the funds strategy of passive investment. &nalyse and explain the onept o" passive investment to your lient, and desribe ho! the "und mana'er uses an index "und to ahieve a spei"i per"ormane outome% (/3 6%0) Passive investment involves the selection of shares in an investment portfolio based on shares included in a published stock market index, that is, a managed fund share portfolio is structured to replicate a specific share market index. "n index is a grouping of shares listed on a stock exchange that sho#s changes in the overall prices of those shares day to day. -ach stock market has its o#n set of indices. 'ell kno#n international indices include the Bo# Cones Industrial "verage 3<%"5, :/%- 3<D5, Eikkei 22$ 3Capan5, and Fang %eng 3Fong Dong5. If a passive investor #ishes to obtain returns on a share portfolio e)ual to the return achieved by the Bo# Cones then the investor #ill purchase the thirty stocks included in that index. "nother investor may replicate a sector index such as the telecommunications sector, or the industrials sector. " number of managed funds are index funds. Index funds use a range of sophisticated techni)ues to replicate or track the share market, including full or partial replication of a specified stock market index. :ull replication occurs #hen a funds manager purchases all the stocks included in an index. Fo#ever, #ith a large index such as the %AP$00, the funds manager may only hold a percentage of the $00 stocks, so long as sufficient stocks are held to ensure the portfolio fundamentally tracks the index. /he funds manager buys and sells shares in order to maintain the replication of the index over time.,% Jack and Jill have recently married and have decided to start buying shares for an investment portfolio. (LO 6.2)(a) Explain the role o" a stokbroker in the diret investment approah to share investments% " stockbroker has access to the trading and settlement systems of a stock exchange. " stockbroker acts as an agent for a buyer or seller of securities listed on a stock exchange. .rokers add to the efficiency and integrity of the stock markets in that they must gain minimum education and training standards, and abide by the rules of the stock exchange and the nation-states Corporation Law. Bevelopment of electronic trading and settlement systems and greater investor access to the internet has radically changed ho# stockbrokers function. 4ombined #ith this has been increased investor kno#ledge, a more affluent aging population preparing for retirement, globalisation of the investment markets, investor demand for higher performance outcomes, and significantly increased competition for the provision of broker services.(b) Within the ontext o" servies provided by a stokbroker2 disuss the t!o main types o" stokbrokers that an investor may hoose to use% 5i""erentiate bet!een the servies provided by these brokers% %tockbrokers may be categorised as discount non-advisory brokers or full service advisory brokers.Biscount non-advisory brokers? only accepts buy or sell orders from clients provides no advice or recommendations to the client in relation to investment alternatives orders are initiated by the client either phoning the discount broker, or more likely, entering an instruction to buy or sell electronically via the internet brokerage fees of a discount broker #ill be lo#er than the fees of a full service broker, for example, in "ustralia, discount brokers fees generally range around 22, to 23, per transaction for transactions up to 210 000 in value and a percentage fee 3ranging from 0.31 per cent5 above that amount.:ull service advisory broker offers advice and recommendations to clients on investment choices and strategies. /heir range of services includes? buying and selling shares on the instruction of clients providing investment advice on securities listed on a stock exchange, including shares, fixed interest securities, derivatives and listed trusts giving advice on other non-listed investment opportunities, such as cash management trusts, property and e)uity trusts making recommendations, establishing and monitoring financial plans for clients= preparing retirement plans for clients, including superannuation conducting research, forecasting and disseminating information on investment opportunities to clients fees8typically charge either a flat fee ranging up to 2120 or a percentage of the transaction, ranging from 2.$G for smaller value transactions, usually less than 2$ 000, do#n to 1.0G for larger transactions over 2$0 000.6. Condor Limited is listed on the ASX and earns part of its income in Australia, and part overseas where it is required to pay tax overseas. The Australian company tax rate is 30 per cent. Condor Limited can provide dividend imputation to Australian shareholders from Australian tax paid. Assume the shareholders marginal tax rate is 37 per cent, plus 6ediare levy. The investor receives a 70 per cent partly franked dividend of $12 700.00. (LO 6.6) (a) Explain the dividend imputation proess% 'ith the "ustralian dividend imputation system, dividends on #hich the company has already paid "ustralian company tax are referred to as franked dividends. " company is able to pass the benefit of the "ustralian tax paid on profits to its shareholders. :or personal taxation purposes, the franked dividend received by the shareholder is grossed-up by the franking credit and the total amount is included in assessable income. :ranking credit @ franked dividend x company tax rate 18company tax rate /he individual shareholder is entitled to receive a franking rebate up to the amount of the franking credit.(b) Why mi'ht a dividend be only partly "ranked# If a company derives part of its profits overseas and does not pay "ustralian company tax on those profits then it is unable to pass on a tax credit on associated dividend payments. /he company may only pay a partly franked dividend based on the tax paid on profits on #hich "ustralian company tax has been paid.() Calulate the inome tax payable by the investor% 4alculation of tax payable?dividend received 3(0G partly franked5 212 (00.00plus franking credit H3212(00 x 0.(5 x 0.3I0.(J 23 +10.00income included in tax return 21& $10.00tax liability 321&$10 x 3+.$G5 2& 3$&.3$less franking credit paid by company 23 +10.00/ax payable 22 $!&.3$7% (a) Explain !hat is meant by the liquidity o" a ompany% 5e"ine t!o ommon aountin' measures o" liquidity% (/3 6%4) /he li)uidity of a company relates to its ability to have access to sufficient cash to meet its current commitments, such as, pay variable costs including electricity, rates and creditors, and take advantage of future trading opportunities, that is, conduct existing and ne# business operations. /#o common accounting ratios used to measure the level of li)uidity of a company are the current ratio and the liquid ratio. 1. 4urrent ratio @ current assets 3maturing #ithin one year5 current liabilities 3due #ithin one year52. 7i)uid ratio @ current assets8inventory 3stock on hand5 current liabilities8bank overdraft /he li)uid ratio provides a more realistic vie# of a companys li)uidity position because in a li)uidity crisis a company may not be able to sell its inventory.(b) Why is liquidity an important indiator that an investor should onsider !hen analysin' share investment opportunities# " company #ith a higher li)uidity ratio has a healthier li)uidity position. 4urrent li)uidity levels should be compared #ith historic levels having regard for changes to its business operations over that period. 7i)uidity ratios #ill vary bet#een companies depending on their reputation and access to sources of funds, and particularly bet#een industry groupings. 7i)uidity ratios are an indicator of #hether a company has the capacity to meet its on-going commitments and take advantage of trading opportunities. Eeed to maintain a balance bet#een li)uidity and investment return trade-offs. 4ompare the li)uidity ratios of a company #ith those of similar #ell-performed companies in the industry. <nderstanding the li)uidity of a company is one measure of the level of risk associated #ith an investment in that company.8% 5e"ine the ommonly used measures o" the pro"itability o" a "irm% Whih measure do you onsider to be most in"ormative in omparin' the pro"itability o" "irms aross di""erent industry setors# (/3 6%4) /he profitability of a company may be represented by a range of different accounting ratios. " ratio that allo#s for comparisons to be made bet#een companies #ith different capital structures is?-.I/ to total funds ratio @ -.I/ total funds employed 3shareholders funds and borro#ings5 " variation of the above ratio is to exclude short-term funding. /his eliminates the effects of seasonal fluctuations in the amount of short-term debt used by some companies?-.I/ to long-term funds ratio @ -.I/ long-term funds 3total funds8short-term debt5 " further measure of profitability is the return on shareholders funds? "fter-tax earnings on shareholders funds @ profit after tax shareholders funds -ach measure of profitability provides valuable information on company performance. It is important to compare the current performance measure #ith the past e)uivalent measure for that company. /here is a need to consider the performance of other companies in the same industry. ;ariations of earnings on shareholders funds bet#een industry sectors indicates that factors other than profitability must be considered, including level of risk, cycle of an industry sector and timing of an investment opportunity.9% (a) 5e"ine t!o measures o" a ompany:s debt;serviin' apaity% (/3 6%4) " companys capacity to generate li)uidity to meet its day-to-day cash flo# commitments and to ensure its solvency is of critical importance. " measure of a companys solvency, or its capacity to service debt, is the debt to gross cash flo# ratio. /his ratio compares the amount of debt outstanding #ith the gross cash flo# 3#here gross cash flo# is defined as net profit after tax, plus non-cash charges, e.g. depreciation5. /his ratio provides an indication of the number of years re)uired, based on current cash flo#s, to repay the total debt of the company. "nother measure is the interest cover ratio. /his ratio represents the number of times a companys interest charge is covered by its earnings before finance lease charges, interest and tax. /he higher the ratio, the greater is the companys ability to cover its interest commitments.(b) Explain !hy it is not appropriate to ompare2 on the basis o" the identi"ied measures2 ompanies in di""erent industry lassi"iations% It is not appropriate to compare ratios bet#een different industry classifications #ithout analysing the debt-servicing practices and capital structures adopted #ithin various industries= for example, some industries #ill normally maintain higher levels of debt to e)uity ratios #hich in turn #ill impact upon their debt-servicing ratios. *ther industries may normally hold lo#er levels of debt, #hile others may hold mainly short-term debt. Bepreciation levels may also vary substantially bet#een industry sectors.0-% & orporation:s prie to earnin's ratio ()/E) is a ommonly used measure in the analysis o" share investments% &n investor !ho is analysin' t!o retail setor orporations notes their )/E ratios "or the past three years(200, 2010 2011%upermarkets 7td 2&.( 22.$ 23.+1rocery 4hain 7td 2(.$ +!.( 1,.$(a) 5e"ine the calculation and discuss the meaning and purpose of a )/E ratio% /he price to earnings ratio 3PI-5 is the market price of a companyKs shares divided by its earnings per share. /he PI- ratio is an indicator of investorsK evaluation of the future earnings prospects of a firm, rather than an indicator of its past performance. If good earnings gro#th is expected the PI- ratio #ill rise, but #here there is less optimism about the future prospects the PI- ratio #ill fall. ;ariations #ill be evident bet#een companies #ithin the same industry sector and bet#een sectors. /his implies that the prices have ad6usted to reflect anticipated changes in future earnings. /he PI- ratio is conceptually simple, but difficult to calculate and interpret. /he ratio for a company can vary from one published source to another, depending on the earnings figure used in the calculation. /he ratio should use expected future earnings, ho#ever, there are likely to be as many estimates of future earnings figure as there are investment analysts. 'hen interpreting PI- ratios published in the financial press, keep in mind that they #ill have been calculated using the immediate past earnings figures.(b) &nalyse and interpret the data in the table% (/3 6%4) .oth companies are in the same industry sector. In 200, both companies had similar PI- ratios #hich indicate earnings forecasts #ere also similar. In 2010 the PI- ratio for 1rocery 4hain 7imited increased significantly indicating a severe do#nturn in actual earnings. /he share price should be expected to fall. "lso in 2010, the ratio for %upermarkets limited fell, indicating that this company had in fact improved its competitive performance. In 2011 #hile the PI- ratio for %upermarkets 7imited had remained fairly stable over the period, the PI- ratio for 1rocery 4hain 7imited has fallen belo# that of its competitor and indicates that the share price has fallen significantly. /here is a possibility that earnings have increased, but given the comparative performance of 1rocery 4hains 7imited in 2010 this may be unlikely. "n investor #ould need to investigate #hether the improved PI- #as a result of a falling share price, improved earnings forecasts, or a combination of both. /he PI- ratio is one measure of performance and other measures should be analysed to try and confirm the above analysis.00% *raes . *its /imited pays a onstant dividend o" +-%4, ents per share% & "unds mana'er is onsiderin' purhasin' the shares as part o" an investment port"olio% The "unds mana'er requires a return o" 1- per ent on the investment% Calulate the prie that the "unds mana'er !ould be !illin' to pay "or the shares% (/3 6%,) If dividend payments are expected to remain constant, such that B0 @ B1 @ B2 @ L. Bn, the share price can be calculated based on a perpetuity. /he present value of a perpetuity is the cash flo# divided by the relevant discount rate?P0 @ B0 I rs .ibsA.obs 7imited is expected to pay a constant dividend of 20.!$ cents per share, and the funds managers re)uired rate of return is 20G, therefore? P0 @ 0.!$ I 0.20 @ 22.2$01% The last dividend paid to shareholders by 6e'a *ank /imited !as +0%6, per share% The board o" diretors o" the bank plans to maintain a onstant dividend 'ro!th poliy o" 6%1, per ent% &n investor2 in evaluatin' an investment in the bank2 has determined that she !ould require a 0, per ent rate o" return "rom this type o" investment% I" the urrent prie o" 6e'a *ank shares in the stok market is +06%4$2 should the investor purhase the shares# (<ho! your alulations%) (/3 6%,) >ega bank is planning to maintain constant dividend gro#th. /herefore, the next dividend paid #ill be the last dividend multiplied by the gro#th rate?P0 @ B0 31 M g5

I 3rs8g5 @ 1.&$ 31.0&2$5 I 30.1$ N 0.0&2$5 @ 220.03 "t a current market price of 21&.!3 the investor should consider buying the shares.0$% <antos /imited has delared a +-%4, ents per share dividend2 payable in one month% &t the same time the ompany has deided to apitalise reserves throu'h a one;"or;three bonus issue% The urrent share prie at the lose o" business on the "inal um;dividend date is +04%7-% (/3 6%,)(a) Explain the strate'y adopted by the ompany% In your ans!er de"ine the terms =um;dividend: and =ex;dividend:% /he company #ishes to restructure its balance sheet by converting reserves into ordinary shares through the provision of bonus shares to existing shareholders.o assumption? dividend is not payable on bonus share issueo cum-dividend8the situation #hen a share price incorporates an entitlement to receive a declared dividendo ex-dividend8the share price after a declared dividend has been paid in cash to shareholders.(b) Calulate the theoretial prie o" the share a"ter the bonus issue and the dividend payment have ourred% 4alculate the theoretical share price?cum-dividend share price 21!.(0dividend paid 0.!$ex-dividend price 21!.2$cum-bonusIex-dividend price 21!.2$market value of 3 cum-bonus shares 2!2.($market value of ! ex-bonus shares 2!2.($theoretical value of ex-dividendIex-bonus share 210.&+04% >omani /imited has a urrent share prie o" +7%6-% The ompany has made a renouneable ri'hts issue o""er to shareholders% The o""er is a three;"or;ten pro;rata issue o" ordinary shares at +7%4, per share% (/3 6%,)(a) Explain the e""et o" the o""er bein' renouneable% 9ights issue8the issue of additional ordinary shares to existing shareholders on a pro-rata basis relative to their existing shareholding 9enounceable8the right is listed on the stock exchange and the shareholder is entitled to sell the right to a third party rather than accepting the offer.(b) What is the prie o" the ri'ht#1price5 on subscripti - price rights 3cum right of value+=NN#here N is the number of shares re)uired to obtain the rights issue share, and the subscription price is the discounted price of the additional share. /herefore?cents $! . 113333 . !!,,, . 0 23333 . !5 !$ . ( 2 &0 . 1( 32 3333 . 3 right of ;alue==

=() Calulate the theoretial ex;ri'hts share prie%cum-rights share price 2(.&0>arket value of 10 cum-rights shares 2(&.00plus?ne# cash introduced through take-up of 3 for 10 issue 222.3$gives?market value of 13 ex-rights shares 2,+.3$therefore?theoretical ex-rights share price 2(.$&$!(d) Explain !hy an atual ex;ri'hts prie o" a share may at times di""er "rom the alulated theoretial prie% (/3 6%,) /he ex-rights price may not fall to its theoretical value because of the informational content of the rights issue. /he increased e)uity base may indicate increased gro#th and profitability thus allo#ing the company to maintain its current dividend rate.0,% <.) Indies mana'es a 'lobal industry lassi"iation standard (?IC<) "or share;market industry setor indies% The standard omprises 0- international industry setor indies% (/3 6%6)(a) What is the purpose o" share;market indies# " stock market index provides a )uantitative measure of the performance of a share market, or an industry sector #ithin the market. 4hanges in an index over time reflects the mood of the market8bull market or a bear market.(b) @o! does the existene o" standard international industry setor indies "ailitate 'lobal investment# Passive funds managers in local and international markets #ill replicate a selected index for an investment portfolio in order to obtain a return e)ual to stocks incorporated in that index.() Identi"y and brie"ly explain the struture o" the ?IC< indies% 1lobal industry classification standard 31I4%5 comprises 10 standard international industry sectors?o energyo materialso industrialso consumer discretionaryo consumer stapleso health careo financialso information technologyo telecommunication serviceso utilities In addition, a country may add further sectors that recognise particular strengths #ithin that market= for example, "ustralia has further sector classifications for financial excluding property trusts, and property trusts.